ECO 316 Week 2 Chapter 7 Risk Structure and Term Structure of Interest Rates

In this document of ECO 316 Week 2 Chapter 7 Risk Structure and Term Structure of Interest Rates you will find the answers on the next questions:

7.1 Multiple Choice Questions

1) The risk structure of interest rates refers to

2) Default risk arises from the fact that

3) If the average risk premium of corporate bonds increases,

4) Currently, a three-month Treasury bill pays 5% interest and a ten-year Treasury bond pays 4.7% interest. What is the risk premium of the typical A-rated corporate bond that pays 5.5% interest?

5) Currently, a three-year Treasury note pays 4.75%. Assuming that your tax rate is 20%, what is the minimum interest rate that you would you need to earn on a tax-free municipal bond in order to buy it instead?

6) When a company whose ability to repay its obligations in full is uncertain borrows funds

7) Default risk

8) Which of the following is considered a default-risk-free instrument?

9) U.S. Treasury securities

10) The default risk premium is measured

11) The default risk premium is

12) The default risk premium

13) Risk-neutral savers care

14) Savers generally are

15) Because savers are generally risk-averse

16) Savers who are risk-averse

17) Investors often pay professional analysts to gather and monitor information on the creditworthiness of borrowers because

18) Which of the following assigns widely-followed bond ratings?

19) Bond ratings

20) Which of the following is the highest bond rating assigned by Moody's Investors Service?

21) Which of the following is the lowest rating given to an investment-grade bond by Standard and Poor's?

22) Which of the following bond ratings by Moody's Investors Service would NOT be considered to be below investment grade?

23) Which of the following statements about junk (high-risk) bonds is true?

24) The default risk premium fluctuates mainly

25) If lenders anticipate no changes in liquidity, information costs, and tax differences, the yield on a risky security should be

26) A flight to quality refers to a shift by savers from

27) If information becomes available indicating that a company's profits will be much less than previously believed, the flow of funds into the market for its securities will decline

28) In the early 1980s, when a recession raised concern about corporations' ability to repay debt, there was a dramatic increase in

29) During the recession of the early 1980s the prices of U.S. Treasury securities

30) During the 1974-1975 recession, the rate on commercial paper increased relative to the rate on T-Bills. This was an indication of the fact that

31) In August 1998, the risk premium rose because

32) A company that retains a high bond rating during a recession in which many other companies see their bond ratings cut will experience

33) The greatest appeal of U.S. Treasury securities is that

34) The flight to quality during the early years of the Great Depression resulted in

35) The default of the Penn Central Railroad in the early 1970s

36) The liquidity premium

37) The risk premium

38) Suppose that savers become much more willing to purchase a certain type of municipal bond. The result will be that the bond's price will

39) Suppose that savers become less willing to purchase medium-quality corporate bonds. The result will be that the prices of medium-quality corporate bonds will

40) Financial instruments with high information costs

41) The existence of rating agencies has

42) Government obligations, such as Treasury bills and bonds, have

43) Financial instruments with high interest rates due to higher information costs

44) Suppose that information costs fall with respect to medium-quality corporate bonds. The result will be that the prices of medium-quality corporate bonds will

45) Differences in the taxation of returns

46) Municipal bonds are issued

47) Interest on most bonds issued by state governments is

48) Many savers are willing to accept a lower interest rate on municipal bonds than on comparable instruments because

49) Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state and local tax rates is 5%, and the yield on thirty-year U.S. Treasury bonds is 10%. You would be indifferent between buying a thirty-year Treasury bond and buying a thirty-year municipal bond (ignoring differences in liquidity, risk, and costs of information) if the municipal bond has a yield of

50) Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state and local tax rates is 5%, and the yield on a thirty-year corporate bond is 10%. You would be indifferent between buying this corporate bond and buying a thirty-year municipal bond (ignoring differences in liquidity, risk, and costs of information) if the municipal bond has a yield of

51) Interest and capital gains are taxed differently in the United States in that

52) Holding all other factors that affect yields constant, following passage of the Tax Reform Act of 1986which lowered marginal income tax ratesyields on

53) If the federal government replaced the current income tax with a consumption tax

54) According to the National Bureau of Economic Research an increase in risk premiums is

55) The yield on commercial paper minus the yield on U.S. Treasury bills

56) If a country has a poorly functioning risk structure of corporate bond yields,

57) The term structure of interest rates

58) The term structure is usually defined with yields on which securities?

59) When the yield curve is downward-sloping

60) Which of the following is NOT true of the yield curve for U.S. Treasury securities?

61) Which of the following statements is true of the yield curve?

62) Which of the following is true of the segmented markets theory?

63) The segmented markets theory

64) The segmented markets theory

65) The yield on a thirty-year Treasury bond is 8% at the same time as the yield on two-year Treasury note is 5%. This occurrence

66) What is the most important contrast between the segmented markets theory and the expectations theory?

67) The expectations theory suggests that

68) If the expected path of interest rates on one-year bonds over the next five years is 2%, 4%, 3%, 2%, and 1%, the expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity of

69) The implication of the expectations theory that expected returns for a holding period must be the same for bonds of different maturities depends on the assumption that

70) A one-year bond currently pays 5% interest. It's expected that it will pay 4.5% next year and 4% the following year. The two-year term premium is 0.2% while the three-year term premium is 0.35%. What is the interest rate on a two-year bond according to the preferred habitat theory?

71) A one-year bond currently pays 5% interest. It's expected that it will pay 4.5% next year and 4% the following year. The two-year term premium is 0.2% while the three-year term premium is 0.35%. What is the interest rate on a three-year bond according to the preferred habitat theory?

72) According to the preferred habitat theory, what does a flat yield curve indicate?

73) A steep yield curve may be an indicator of

74) According to the preferred habitat theory, the yield curve normally has a positive slope because

75) Which of the following statements is true?

76) According to the expectations theory, if investors believed that, for a holding period the average of the expected future short-term yields was greater than the long-term yield, they would act so as to

77) Under the expectations theory if market participants expect that future short-term rates will be higher than current short-term rates, the yield curve will

78) Unlike the segmented markets theory, the expectations theory attributes the slope of the yield curve to

79) The expectations theory

80) Which of the following is NOT true of the expectations theory?

81) For the post-World War II period,

82) The key assumption of the preferred habitat theory is that investors

83) According to the preferred habitat theory

84) The preferred habitat theory holds that investors

85) If a one-year bond currently yields 5% and is expected to yield 7% next year, the preferred habitat theory predicts that the yield today on a two-year bond will be

86) Which of the following is NOT true of the habitat term premium?

87) Under the preferred habitat theory the shape of the yield curve depends on

88) Under the preferred habitat theory, the expectation that future short-term rates will be constant results in a yield curve that

89) Under the expectations theory, an upward-sloping yield curve indicates that investors expect future short-term rates to

90) Under the preferred habitat theory, a flat yield curve indicates that investors expect future short-term rates to

91) If market participants expect that inflation in the future will be lower than it currently is, the yield curve will

92) In which of the following periods was the yield curve inverted?

93) If the preferred habitat theory is correct, a reduction by the Treasury in the supply of 30-year bonds should

7.2 Essay Questions

1) Steve Forbes has run for president twice on a program of a "flat tax." Under a flat tax, there would be only one tax bracket for the federal income tax and most tax deductions and tax exemptions would be eliminated. Suppose that Forbes wins the 2008 presidential election. What would be the likely impact on the market for municipal bonds?

2) Suppose the private bond rating agencies ceased to exist. What would be the impact on the bond market?

3) Discuss what happened to the market prices on corporate securities relative to government securities during the years 1929-1931.

4) If the expectations theory of the term structure is correct, would a reduction in the supply of thirty-year Treasury bonds affect their yields?

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